Conference Take-Aways: HiFREQ TRADE 2011

28 February 2011 - Latency measured in nanoseconds, FPGA's, ongoing systemic risk and worries over knee-jerk regulatory changes, were just some of the topics discussed at this year's HiFreq Trade Conference in London. Conference Chairman and regular Automated Trader contributor, Bob Giffords, offers his insights into the key points raised at the event.

There was a real buzz at the February HIFREQ TRADE conference
this year as over 250 people debated the way forward for the most
astonishing transformation ever in the capital markets. The
technology was amazing, the regulatory threats 'scary', and the
quantitative ambition, awe-inspiring. One got the impression we
are now trading on the 'edge' with a shadowy abyss of flash
crashes looming below as we scale boldly up to the complexities
and speed challenges of 21st century global electronic
markets. As I think back on the day these are some of the many
messages that stood out for me both from speakers and private
discussions alike.

Black Holes Beckon

The big story this year was FPGA chips with everything, but
especially for feed handlers that moved together with multi-core
trading engines onto the network cards to get a little closer.
People are now talking about simple trading apps converging on
latencies of single digit microseconds. 10 gigabit Ethernet with
RDMA is also spreading out from the exchanges to directly
connected robotraders in the co-location hubs over one-hop
switches spanning the data centre. Everything is being
time-stamped to mind-numbing nanoseconds, i.e. billionths of a
second. Last year the latency target for exchanges was 200
microseconds, this year it is below 100 microseconds and some
think they can get that down to 20 microseconds perhaps even next
year, a 10 fold improvement in something like 2 years.

Brokers too have squeezed their pre-trade risk checks into 3
microseconds using FPGA and native exchange protocols. This is
over 80 times faster than some FIX DMA offerings and appears to
have lifted fill rates substantially, even to 90% in some cases,
but such advantages will inevitably be eroded as competitors
match the technology.

Meanwhile, more and more complex risk management is proceeding
asynchronously out-of-band, but still at wire speeds. Waiting in
the wings of course are GPU chips and 40 gigabit Ethernet that
can bring terascale technology to crunch complex analytics in
real-time too. Perhaps that will be the story next year when the
pioneers report their progress.

Conventional multicore chips, of course, are fighting a rearguard
action coming close to FPGA for feed handling on average, but
tending to fall behind in the microbursts. Yet they offer much
smarter and more agile solutions, so some people prefer them.

Another strategy was split co-location with dynamic allocation of
trades and asynchronous secondary messaging between them.
Designing the control models for these distributed algos is
probably more important than people are letting on. Thus, there
are real choices for smart infrastructure, adapting the hardware
to the trading strategy. Where will it end? The technologists
told us we are still accelerating into these ever-decreasing
microcosmic circles with no end in sight.

Naturally everything has to be optimized - even the time-sharing
algorithms on the chips, the power interrupts or use of Level 2
cache. Reflective memory chips that autonomously copy data around
the network are another quick trick to save a few more CPU
cycles.

How do we benchmark ourselves against the competition? Here too,
help apparently is at hand, since some exchanges are now
time-stamping all orders when they acknowledge them and then
publish those of the fills as well. This allows firms to estimate
how close they were to the trade. Other firms track drift in
these timestamps to infer bottlenecks for smart-order-routing
decisions. Another speaker reported using FPGA chips as well to
replay price feeds for realistic backtesting benchmarks, accurate
to the nanosecond. For those with ears to hear there were many
useful tips of the trade.

Predictable Surprises Ahead!

There was much more anxiety this year over what regulators might
do. Sometimes they make quite benign comments about the
efficiencies of high-frequency traders, while at other times
threaten heavy regulation: minimum order resting times, maximum
tick-to-trade ratios, charging for cancels, imposing market
making obligations on high-frequency access, short selling rules
etc. It is not clear what all this is trying to achieve since
many such initiatives may just restrict competition further and
widen spreads, as happened when the regulators last struck over
short selling. The investor will pay in the end as these
regulatory costs rise, but few regulators appear to worry about
that.

The basic idea seems to be that like everything else in life
there is a need for speed limits. In Europe we have done that to
date with volatility interrupts which have fairly small costs and
only kick in for the fat tail events. The US had a weaker
microstructure made worse by the trade-through rules that failed
in the Flash Crash. Yet now the regulators want to penalise
everyone, and some more than most. Indeed the EU too is
suggesting that if proprietary firms are direct members of
exchanges, they need to be regulated and ensure their systems are
robust. There is no evidence that failing prop trader technology
caused the flash crash. One might therefore be forgiven for
concluding that regulators seem to want innovation but not if it
gives someone an advantage. What else is innovation for?

Someone asked innocently why exchanges themselves are never fined
for failing to ensure fair and orderly markets? A timely
observation given LSE Group's glitch the following day.
Apparently 'fair and orderly' obligations for exchanges are quite
limited, so members need to protect themselves: caveat emptor.
Yet if exchanges are not responsible for protecting markets,
high-frequency traders somehow become responsible for any
indirect loss they might cause. There seem to be some mixed
messages here. There was widespread concern that the regulatory
focus on high-frequency traders was allowing the markets to
tolerate an unacceptably poor level of quality, which clearly
creates large externalities and potential fat tails.

Regulators are also mandating increasing risk checking by
brokers. Best practice currently was said to include credit and
liquidity checks, fat finger checks, anti spamming checks, open
order exposures to limit ratios etc. with some allowance for
cancelled trades as well. Besides their compliance obligations,
brokers are implementing these checks both to protect themselves
against loss and to increase business through differential risk
pricing.

The most 'scary' thing for one market participant was a
heavy-handed, knee-jerk response to the flash crash. The
consensus seemed to be that the regulatory future truly hangs in
the balance. There is a lot of suspicion and not a lot of trust
on both sides. Compare the pre-flash crash world of last year's
HIFREQ TRADE conference that presented a much more benign view of
regulation. Once again there were reassurances, but the politics
are clearly complex. Some intervention now appears more likely.

Lofty ambitions

Speakers noted that single market opportunities for high
frequency strategies are rapidly eroding, as everyone spots the
gaps and piles in. Thus traders are looking for more complex
plays: multi-asset class, multi-geography, multi-instrument
correlations, arbitrage of dual listed securities, etc. The mind
boggles at the sheer audacity of some of the strategies under
discussion. Thus traders are resorting to ever more dynamic
adaptive models, ever more frequent recalibration, and ever
shorter half-lives before models are replaced. However, since
more complex strategies are less likely to be challenged or offer
natural barriers to entry, they apparently need much less
frequent re-calibration and have relatively longer half-lives. In
effect they are truly smarter.

In emerging markets key high-frequency issues are liquidity, the
availability of suitable futures or other leveraged hedges, the
availability of deep sources of stock loans for short selling
strategies, and broker cross-margining capacity. While important,
technology is very much secondary to these business issues,
although some thought that the availability of a local
point-of-presence (PoP) can be helpful for some of the lower
speed players. However, network distances are long and relative
value plays between exchanges can be very expensive. So
high-frequency traders will often co-locate at both ends with
asynchronous signals between them.

In some ways emerging markets are even overtaking their western
competitors. Apparently Brazil and Russia, for example, both do
exchange-based, real-time pre-trade checks to make sure buyers
have the money in the broker's central bank account or sellers
have the securities in their custodial accounts with same or next
day settlement. This completely changes risk profiles, eliminates
naked shorts by implication and presumably modestly slows down
the flow as well. Brazil requires separate accounts for
beneficial owners, not omnibus accounts, and offers cross-asset
order types to facilitate complex spread or contingent trades -
all very 21st century features. Not only does this
give more transparency, but it creates new high-frequency
strategies as well. If the advanced economies lose their
innovative edge, there are huge implications for global
competition and regulation.

Quants are apparently still making money with growing volumes,
but their market sentiments are overwhelmingly neutral with as
many bears as bulls and little change anticipated in the
uncertain macro economic landscape. One quant commented how ideal
this was for high-frequency strategies. Consistent with these
survey findings, most quant traders were expected to hold their
investment at current levels, while some are increasing, but few
reducing it.

The growing demand for smart and diverse infrastructure to
support diverse and changing trading strategies was said to
reduce infrastructure half-lives and thus encourage outsourcing
and huge economies of scale for infrastructure providers. Yet
40-50% of high frequency traders still apparently 'roll their
own'. Are suitable third party offerings not available or are
these firms failing to recognize the opportunity costs of
in-house builds? Speakers highlighted how multi-supplier
outsourcing potentially offers a greater choice of feasible
strategies.

From this perspective, current exchange consolidation may be
positive if it increases global competition, even at the cost of
local competition. Regulators will need to tread carefully to
balance such imponderables, since the lobby legions are on the
march.

Fragmentation was described as a dream come true for
high-frequency traders by providing them with a sustainable
business model to arbitrage the liquidity venues for stable price
discovery. Indeed most of the time volatility is now lower.
However, when market sentiment sours, volatility can spike
dramatically. The "burstiness" of fast markets was frequently
emphasized.

Here cross-margining across venues becomes critical which is good
for those global brokers, who have the necessary scale and depth
to provide the requisite technology, global access, credit and
high rates of innovation. Given these economies of scale and
network effects the big brokers are busy scaling up and out, but
few, it appears, can currently reach out to the many emerging
markets and cover all the asset classes holistically. Competition
clearly will be heating up.

Someone pointed to the growth in exchange-traded funds (ETF) and
the regulator-inspired move from OTC to exchange-traded
derivatives (ETD) as being key drivers for future high-frequency
growth. Apparently ETFs in the US have risen from 21% of market
flows to 35% over the past couple of years although in Europe it
was still said to be down around 5%. This creates important
high-frequency opportunities to arbitrage the indices to the
futures contracts and also to the underlying cash baskets, while
on-exchange swaps can integrate pricing off global futures
benchmarks much more rapidly. These could create a new frontier
beyond fragmentation. Since ETFs and ETDs are also potentially
helping to increase correlation, it could however just lead to
crowded trades and more black swans, proving once again that
every silver lining has a dark cloud looming in the background!

This drive for diversity is focusing attention on algorithms and
models, with relatively less emphasis on technology. Here 3 key
drivers of quantitative strategies were highlighted:

Commoditisation of technology, driving the search for new
data to support trading strategy decisions.

Increasing diversification, encouraging research into
understanding the investor.

At the same time these trends were also enabling low frequency
traders to capture much more alpha. So interest is shifting to
the trade-offs between research, technology and the trade-risk
balance with a rich harvest of new niches that quantitative
traders can exploit. In response, exchanges are looking to
provide new data streams, such as latency, but also new
microstructures. For example one global exchange was said to be
considering price-size rules for the matching engine as an
alternative to price-time rules. This potentially might shift the
emphasis from speed to smart models and compute intensity. Others
were said to be considering different commercial incentives to
liquidity providers, order types to exploit penny ticks, a new
mix of lit and dark order types, etc. Regulators too may
accelerate such microstructure evolution, if for example they
require some price improvement in dark pools.

The biggest challenges for quantitative traders apparently are
not capacity limits, but rather the need to limit transparency to
protect their intellectual property, yet still effectively
communicate their strategies to investors who are being
increasingly inquisitive. There is less trust in the black box,
and more demand for transparency and due diligence. Squaring this
particular circle will not be easy.

Current market challenges are forcing firms to focus more on
downside risks and controlling the unknown unknowns by leveraging
insights from extreme value theory, which lets you model things
that are interdependent and therefore co-evolve. Quants are
realizing that with so many things changing at the same time, it
is difficult for any model to cope with uncertainty.

One fascinating speaker argued that long only firms often create
profit opportunities for high-frequency traders because of poor
communications between portfolio managers and their own traders.
He challenged us to think of order books, at any time, as
essentially a long-short portfolio strategy: you are long
everything you want to sell and short everything you want to buy
until the trades are done. If the trader does not look at the
basket with these long-short dynamics, he leaves money on the
table for the high-frequency traders. The solution apparently is
to improve internal communications by focusing on the following:
alpha decay rates, risk models for security returns, agency
trading costs, likely market impact both temporary and permanent,
and investor risk aversion. While admitting that such parameters
are difficult to estimate, the speaker suggested that news
analytics might provide some helpful proxies and alternatives to
GARCH based models. He stressed that if variance itself is
variable, then it becomes very difficult to estimate. We were
left wondering how many quantitative models may be open to such
uncontrolled errors. Dealing with this fundamental uncertainty
perhaps becomes the next great quest for quantitative analysts.

There was one further thoughtful insight: volatility is always
the same; it is only the pace of change, i.e. time, that varies.
So we need to focus more on the rate of change of volatility, not
just volatility. Indeed, while volatility is definitely not
normally distributed, it can apparently be closely modeled with
varying volatility curves all of which are normal. Yet since
volatility is often a lagging indicator, we need to focus more on
the strains and pressures that are building up to find leading
indicators to the pace of change.

HIFREQ TRADE 2011 provided a wealth of insight, once again
confirming Alvin Toffler's 1970s observation that knowledge is
the fuel that accelerates the pace of change. For those who
attended, may the G-force be with you!